Risk and Return: Portfolio Theory and Asset Pricing Models Answers to End-of-Chapter Questions

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7-1a.A portfolio is made up of a group of individual assets held in combination. An asset that would be relatively risky if held in isolation may have little, or even no risk if held in a well-diversified portfolio.

b.The feasible, or attainable, set represents all portfolios that can be constructed from a given set of stocks. This set is only efficient for part of its combinations.

c.An efficient portfolio is that portfolio which provides the highest expected return for any degree of risk. Alternatively, the efficient portfolio is that which provides the lowest degree of risk for any expected return.

d.The efficient frontier is the set of efficient portfolios out of the full set of potential portfolios. On a graph, the efficient frontier constitutes the boundary line of the set of potential portfolios.

e.An indifference curve is the risk/return trade-off function for a particular investor and reflects that investor's attitude toward risk. The indifference curve specifies an investor's required rate of return for a given level of risk. The greater the slope of the indifference curve, the greater is the investor's risk aversion.

f.The optimal portfolio for an investor is the point at which the efficient set of portfolios--the efficient frontier--is just tangent to the investor's indifference curve. This point marks the highest level of satisfaction an investor can attain given the set of potential portfolios.

g.The Capital Asset Pricing Model (CAPM) is a general equili¬brium market model developed to analyze the relationship between risk and required rates of return on assets when they are held in well-diversified portfolios. The SML is part of the CAPM.

h.The Capital Market Line (CML) specifies the efficient set of portfolios an investor can attain by combining a risk-free asset and the risky market portfolio M. The CML states that the expected return on any efficient portfolio is equal to the riskless rate plus a risk premium, and thus describes a linear relationship between expected return and risk.

i.The characteristic line for a particular stock is obtained by regressing the historical returns on that stock against the historical returns on the general stock market. The slope of the characteristic line is the stock's beta, which measures the amount by which the stock's expected return increases for a given increase in the expected return on the market.

j.The beta coefficient (b) is a measure of a stock's market risk. It measures the stock's volatility relative to an average stock, which has a beta of 1.0.

k.Arbitrage Pricing Theory (APT) is an approach to measuring the equilibrium risk/return relationship for a given stock as a function of multiple factors, rather than the single factor (the market return) used by the CAPM. The APT is based on complex mathematical and statistical theory, but can account for several factors (such as GNP and the level of inflation) in determining the required return for a particular stock.

l.The Fama-French 3-factor model has one factor for the excess market return (the market return minus the risk free rate), a second factor for size (defined as the return on a portfolio of small firms minus the return on a portfolio of big firms), and a third factor for the book-to-market effect (defined as the return on a portfolio of firms with a high book-to-market ratio minus the return on a portfolio of firms with a low book-to-market ratio).

m.Most people don’t behave rationally in all aspects of their personal lives, and behavioral finance assume that investors have the same types of psychological behaviors in their financial lives as in their personal lives.

7-2Security A is less risky if held in a diversified portfolio because of its lower beta and negative correlation with other stocks. In a single-asset portfolio, Security A would be more risky because σA > σB and CVA > CVB.


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